Peter Burgess

The Compensation Scheme of Last Resort (CSLR) revised levy estimate for the 2026 financial year places “a far too heavy burden” on the financial advice sector.

SMSF Association CEO Peter Burgess says the revised levy of $67.2 million for the financial advice sector, when coupled with the recommended special levy of $47.3 million, are simply “too high” for the sector to sustain.

“While the revised estimate is slightly lower than the initial estimate of $70.1 million, we are bitterly disappointed with the quantum of the levy amount that punishes the vast majority of advisers who act in the best interests of their clients.

“The CSLR CEO David Berry explicitly acknowledged this when announcing the levy, saying ‘the harm caused by those in the finance sector doing the wrong thing disproportionately impacts and detracts from those acting correctly’.

Burgess says having the CSLR is an important initiative to build confidence in the financial advice industry.

“But its current funding model is unsustainable and inequitable, posing a risk to the viability of the advice sector and the CSLR,” he says.

“We urge the Government to expedite the review of the CSLR that it commissioned back in January.

“When the review was announced, the Government stated that ensuring the scheme is sustainably funded would be an important focus.

The Association also lamented the occurrence of large-scale advice model failures leading to the ever-increasing CSLR costs for compensation claims.

“It’s not just the scheme itself that needs to be reviewed, it’s what being done “up-stream” by the regulator to detect and act on early signs of advice failures, that also needs to be reviewed.

“By the time the claims reach the CLSR it’s usually too late to avoid or mitigate the cost of compensation”, Burgess says.

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Sinead Schaffer

State Street Global Advisors, the asset management business of State Street Corporation (NYSE: STT), together with Investment Trends, has released a new report revealing the proportion of advisers using managed accounts in Australia has reached a record high of 59%, tripling from 20% a decade ago. A further 16% of advisers have expressed interest in adoption, potentially bringing the total reach to 75% in the coming years.

The 16th SPDR ETFs / Investment Trends Managed Accounts Report (‘the Report’), which surveyed 946 financial advisers across Australia between November 2024 and January 2025, showed that, amidst persistent global economic uncertainty, escalating inflationary pressures, and a rapidly evolving investment landscape, demand for managed accounts continues to be robust.

The Report showed advisers using managed accounts allocate, on average, close to three-fourths (71%) of clients’ total assets into these accounts. Additionally, managed accounts advisers are directing a record 48% of new client inflows to managed accounts, setting a new high—up from 41% in 2024, reflecting the growing prominence of managed accounts as a primary investment structure.

This explains why funds under management (FUM) in managed accounts have surged 23.2% in the 12 months to December 2024 to a record-breaking $232.77 billion^[1] .

State Street Global Advisors’ Vice President and ETF Model Portfolio Strategist, Sinead Schaffer, said: “The growing adoption among the latest cohort of users is primarily driven by the demonstrated value managed accounts bring to both advisers and their clients. While freeing up their time to focus on client engagement is the key benefit of recommending managed accounts, advisers also see using managed accounts as a cost effective way to access professional investment management for their business.

“The research also found that advisers using managed accounts for longer periods reported higher funds under administration (FUA), suggesting that longer-term adopters benefit from more profitable businesses compared to newer users.”

General Performance is the most important factor when selecting a managed account

Ms Schaffer said the top reason for recommending managed accounts to clients is the ability to achieve full asset allocation, with their top selection criteria being performance, fees, ability to achieve full asset allocation, availability on their main investment platform, and reputation of the asset manager.

“Half of the financial advisers chose performance as the most important criteria when selecting a managed account, while availability on the main investment platform has now surpassed fees as the second highest priority,” added Ms Schaffer.

Saving 23.9 hours a week by using managed accounts

This year, the Report again highlighted the time-saving efficiencies of managed accounts with 60% of advisers citing ‘freeing up their time’ as one of the main upsides of using managed accounts. Advisers reported they, or their support staff, save an average 23.9 hours per week as a result of using managed accounts in their practice, up from 22.8 hours a year ago, equivalent to approximately 1,243 hours saved each year.

Investment Trends CEO Eric Blewitt said the time savings allow advisers to focus their efforts on better understanding and supporting client goals.

“Each year more advisers are turning to managed accounts because they allow for a more holistic approach to wealth planning. The ability to tailor portfolios to meet the specific financial and lifestyle goals of clients is one of the leading reasons advisers are choosing to switch to managed accounts.”

“In fact, one in five advisers report being able to offer a more tailored service to clients due to the flexibility these accounts provide. As a result of time saving, 48% of advisers reported redirecting that time to enhance client relationships, while 26% are using it to acquire new clients,” Mr Blewitt added.

Increase efficiency by streamlining the number of managed account models

The Report showed that multi-asset class models are the most widely used, as 68% of advisers recommended the models in the past year. Additionally, the ability to achieve full asset allocation is a key reason advisers recommend managed accounts to their clients.

That said, this year advisers have reduced the number of models they recommend to clients from 18.2 in 2024 to just 12.1 this year.

Ms Schaffer explained: “The due diligence process can be resource intensive, with advisers on average using five tools when conducting their assessment of managed accounts. As a result, both adviser and licensee have reduced this burden and simplified their approach by reducing the number of strategies they recommend.”

SMAs remain the most preferred choice by advisers

The Report showed that 89% of advisers implement managed accounts with separately managed accounts (SMAs) on platform.

Mr Blewitt said: “Among current managed account advisers who use SMAs on platform, 71% of them use off-the-shelf model. However, it is interesting that custom-built SMAs are particularly popular with experienced managed account advisers. They are allocating 57% of new client inflows to these tailored solutions.”

Other key findings:

• Managed account advisers leaned toward growth-oriented (65%) and risk-based (44%) strategies in the past 12 months, but a third remain uncertain which strategies they would use going forward, reflecting macroeconomic uncertainty.
• Separately managed accounts (SMAs) on platform remain the most widely used structure to implement managed accounts. With 89% implementing managed accounts with an SMA on platform.
• 53% noted ETFs are the underlying products in their managed accounts.
• The group of non-users remains substantial at 19%, however they are open to being persuaded by reduction in platform fees and better research.

State Street Global Advisors officially launched its ETF Model Portfolio capability to the Australian market in 2019, through various intermediaries.

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Notes:
[1]  Source: IMAP/Milliman FUM Census, as at 31 December 2024

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The AMP Capital Global Equity Fund is long-only and is the inaugural fund in AMP Capital’s new global equities range.

The fund will focus on absolute risk and return, not benchmarks, and invest in a concentrated portfolio of between 25 and 35 exceptional companies with strong current or anticipated cash generation. The investment time horizon will be long term, leading to low portfolio turnover.

The fund will seek tailwinds of thematic drivers and, where possible, environmental, social and governance tailwinds. Favoured investment themes include changing demographic trends, which will drive major changes in future global patterns of consumption and healthcare, and technology.

David Allen, AMP Capital’s Global Chief Investment Officer, Equities, said: “The launch of the AMP Capital Global Equity Fund is a defining moment for AMP Capital. It represents a highly differentiated investment opportunity for clients following years of work by our team and it is also a trailblazer for how we plan to re-position our broader equity fund range over time. We have built a global equity capability that stands apart from its peers and is in line with what clients tell us they want: process transparency, absolute capital growth, reduced volatility and downside protection. Importantly, the fund seeks to deliver absolute outcomes as it is benchmark unaware.

“We’ve taken a high-conviction approach, investing in a small number of exceptional companies with outstanding prospects, that have dependable and persistent cash-backed returns on capital. As we are not bound to a benchmark, sector or country, these are names that we think are the best stocks globally and will deliver the performance to meet our clients’ goals.”

Mr Allen said AMP Capital’s new global equity fund is underpinned by a strong and collaborative team culture.

“We believe our star team approach – rather than that of a star portfolio manager – leads to better and more sustainable outcomes for clients by managing individual behavioural biases and reducing key person risk,” Mr Allen said.

The investment team is based in London and Sydney, drawing on the strength of the investment professionals in both regions and enabling coverage across time zones.

AMP Capital intends to launch additional global equity products in the coming years.

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New global themes and trends, usually relayed and reinforced by the 24-hour news cycle, have a funny way of overpowering fundamental analysis of markets and economies. My favourite example in 2013 was failed electronics retailer Tweeter, which saw its share price soar by over 1000% when investors caught up in the hysteria over the Twitter IPO mistook its stock code—TWTRQ—for Twitter’s (TWTR). Investors bought 14 million Tweeter shares in a single day.

Granted, this is an extreme example, but in some ways we are all guilty of focusing too much on the investment theme du jour. While these themes can have enormous power to move markets, they often obscure the fundamental story that investors should be focusing on. Below are what I consider to be the most overused and abused phrases and concepts of 2013 (with their prevalence in Google search results) and what we should have focused on instead (it may not be too late!).

Chart 1: Google search results (Source: Google)

“Whatever it takes”

Just three words uttered by European Central Bank President Mario Draghi in July 2012 but which heavily influenced market sentiment well into 2013. Implied by this phrase was an assurance that the Eurozone would not let one of its members fall down. The backstop proved solid as the Cyprus crisis that erupted in March 2013 didn’t cause nearly as much disruption to world markets as its PIIGS predecessors did in 2010, 2011, and 2012. However, Mr Draghi was conveniently long on promises and short on details. Saving the Euro could realistically only be done if the Eurozone transforms itself from a monetary union to a fiscal one. Getting all 17 members to agree to this (especially Germany) is tricky at best, and while an agreement on fiscal union was signed, it has yet to be carried out. Instead of focusing on Draghi’s promise, investors should monitor the implementation of actual reforms (or lack thereof).

“The great rotation”

Refers to the supposedly “secular” change in asset allocation that will see investors abandoning their low yielding fixed interest securities in favour of equities. As is often the case though, most of the rotation had already occurred by the time the media took hold of the story, since sovereign bonds have been overvalued relative to equities for the last two to three years. The Australian version of the “great rotation” that is seeing investors leaving their term deposits in favour of local equities is perhaps a notable exception, as the process is still very much in progress. Overall, there is nothing secular about the change and nothing “great” about the rotation. The yield of the US 10-year Treasury bond has gone up in 2013 and will most likely continue to do so in 2014, as the Federal Reserve slowly withdraws quantitative easing. As bonds become more attractive again, investors will inevitably switch back.

“Search for yield”

A sub-theme of the great rotation, it pertains to investors for whom yield (rather than capital growth) is a primary investment objective, such as retirees. For them, abandoning fixed income investments is only half the equation and an appropriate income stream must be found elsewhere. The solution they opted for en-masse were shares with high dividend yields. This phenomenon has been powerful enough that it created a market distortion nick-named…

“Expensive-defensives”

Defensive, high yielding stocks are traditionally perceived to be more defensive than high growth stocks, and usually priced more conservatively. That is, they tend to lag in market rallies. However, these stocks have undoubtedly led the S&P/ASX 200 Index in 2012 and 2103, earning them the “expensive” label. Indeed, according to most measures of valuation, the likes of Telstra and the four major Australian banks appear expensive at current levels, which means they are likely to lose more than the overall market in a future downturn. So while certainly expensive, they have probably lost their defensiveness. This could be the exception to our rule, because despite extensive use of this term in the media, investors don’t seem to have altered their behaviour. Quite the contrary, some companies have picked up on the trade and are issuing debt in order to pay for dividends, knowing it will increase their share price. The concept of dividend growth sustainability doesn’t seem to have penetrated investors’ consciousness just yet.

“Fracking and shale gas”

Infrastructure investments have been the other main beneficiaries of the “search for yield”. The sales and marketing departments of investment banks have come up with the perfect cover story to sell them: technological advancement leading to productivity gains. Everything started with a supposedly innovative drilling technique called hydraulic fracturing (shortened to “fracking”) that allows gas and petroleum to be extracted from previously hard to reach bedrocks. But fracking was actually first tested in 1947 and the (very real) shale gas boom in the US owes its success to many other factors as well, including high oil prices and pre-existing pipeline networks. While fracking will, in all likelihood, continue to expand, it is fair to assume that the remaining upside in all related investment opportunities is limited. That should include the Australian “gas boom”.  Furthermore, no one has yet been able to explain why, despite the abundant new supply of natural gas, the price of oil has remained near historical highs. The answer to this question is probably the key to successful future investments in energy. Supply and demand anyone?

“Abenomics”

The term used to describe the economic policies of Japanese Prime Minister Shinzo Abe, whose PR team also deserves special mention for having come up with the “three arrows” concept: fiscal stimulus (also known as government borrowing more to spend more),  monetary stimulus (quantitative easing) and structural reforms.  The Japanese Nikkei 225 Index has risen 46.5% YTD on the back of the first two arrows being implemented and the promise that the third one is imminent. With Japan’s debt-to-GDP ratio at 230%, the first arrow can only be pursued with the help of the second, that is, if the central bank buys every bond issued by the government. The central bank is expanding its balance sheet to previously unthinkable levels and Mr Abe appears to have convinced international investors that this can be done ad-infinitum. The sceptics among us believe that at a certain (as yet unquantifiable) point, the sheer size of the central bank’s balance sheet as a percentage of GDP could cause investors to lose confidence and devalue the yen by much more than Abe is targeting, plunging the country in a more severe recession. Only structural reforms can help save Japan, and they are not yet being implemented.

“Septaper” 

The tapering of the US Fed’s quantitative easing measures was set to happen in September, but didn’t. From April on, members of its policy setting body the Federal Open Market Committee started to put out “feelers”, implying that the Fed may reduce the amount of Treasuries it was buying every month (currently still at $US85 billion). The markets took those indications very seriously and long-term bond yields started to rise as a consequence. While the Fed seemed satisfied enough with the slow pace of economic recovery to begin to taper, it deemed the recovery too fragile yet to sustain higher yields and delayed the decision. One cannot blame the financial press for focusing so much attention on an event that is indeed a turning point in the post-GFC recovery, one that we’ve been awaiting for five years. It is, however, regrettable that the adverse side effects and unintended consequences of quantitative easing have gone largely unnoticed. For one, the liquidity provided by the Fed has led to new records in corporate debt issuance, which companies have used to issue higher dividends and buy back more shares, inflating their share prices. Another notable side effect has been the lack of availability of US Treasuries (because the Fed holds so many), which are needed as collateral for many lending transactions. As a result, borrowing has been somewhat restricted, even though QE was originally designed to boost borrowing.

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By Jonathan Tolub, senior asset consultant, van Eyk Research 

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Abe’s election victory ensures QE will continue.

The Japanese Upper House election held on Sunday 21 July was a true test of the country’s attitude to ‘Abenomics’.

The result was resounding support for Japanese Prime Minister Shinzo Abe’s economic agenda as his party, the Liberal Democratic Party (LDP), achieved control of both houses of parliament, something not seen since 2010.

The LDP took control of the Lower House after a landslide election win in December 2012. But up until now, it had to rely on opposition support to get legislation through the upper chamber.

John Vail, Chief Global Strategist at Tyndall AM’s global parent company, Nikko AM believes victory means that quantitative easing (QE) should continue apace. In his view, Abe already had the will, but now has the mandate, to carry through with his economic reform plan at a speed that will be beyond market expectations. The immediate economic reaction may be subdued given that many market participants and global equity investors remain sceptical about structural reforms in Japan. Mr. Vail is not. In fact, he thinks reforms will be even stronger than promised before the election and undertaken with alacrity, in what he calls ‘Super-Abenomics’.

Mr. Vail believes that in time, as the markets realise that this occasion is truly different and serious structural reforms are being implemented, the Japanese stock market should perform well. This would have some wealth effect and help drive domestic consumption. In addition, confidence in government stability, with the next election three years away (barring crisis), should help investment in areas such as corporate capital expenditure and housing. Greater internationalisation should occur with some major reforms, such as allowing a gambling industry and accelerating the restart of the nuclear power plants. Although these will be controversial issues, they should have positive effects on the Japanese economy in the longer term.

Abe has promised a more open, more internationally-minded Japan, which will clearly be a boost to the country’s economy. Perhaps his largest reform promise has been to join the Trans-Pacific Partnership (TPP), which aims to establish a free trade association across the Pacific area (likely excluding China). TPP negotiations resumed on 23 July, with Japan at the table for the first time. Japan must hurry to compromise as negotiations are scheduled to be completed this year. However this will not be easy, as politically strong Japanese farmers and other protected industries must take some of the burden.

Abe is also focused on other areas of reform, such as increasing female participation in the workforce and childcare availability, as well as relaxing laws surrounding part-time labour and ‘stress leave’. The swift implementation of these will be critically important for Japan’s return to competitiveness, as it will help offset the demographic problem. Although the overall corporate tax rate will not likely be cut, Mr. Vail believes that breaks for capital expenditure and R&D should be quite generous.

So what does this all mean for global equity investors?

What is being done now hasn’t been attempted for decades. However, there is growing belief in Japan that this time it will work. It’s not just the politicians who support Abe. While he is clearly viewed as a hero within the LDP, he has the highest long-term approval rating of any Japanese prime minister in modern history. In his speeches, Abe has dedicated his career to economic reform and now that he has control of all the levers, we believe the speed of reform will be a major surprise that will be positive for Japanese equities and the Japanese economy as a whole.

In fact, Japan has already started to show growth under Abe’s monetary and fiscal stimulus, with the Yen weakening and equity prices rising. Consensus for GDP for this calendar year is 1.8%, but Nikko AM expects 2% or higher, with more consistent growth continuing after that. The removal of political headwinds bolsters the government’s ability to press forward with all ‘Three Arrows’ of its growth strategy. In Mr. Vail’s view, even after their good performance of the last year, investing in Japanese equities now makes sense.

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Views from John F. Vail, Chief Global Strategist and Head of Asset Allocation, Nikko AM, parent company of Tyndall AM.

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• Relatively high returns could be expected for such stocks compared with ordinary ones in the medium and long term; and
• Fluctuations in the prices of high dividend yield stocks would be relatively small and the risks involved fairly low.

One year on, the equity market environment has undergone changes. There are signs of slow improvement in parts of the global economy and it is hoped that this trend will continue. The monetary authorities and central banks in various countries have attempted a wide range of actions to boost their economies and, as a result, markets have seen historically low interest rates and high capital liquidity. This has prompted capital inflows into stock markets, boosting stock prices substantially over a short period of time.

However, governments’ fiscal problems are becoming increasingly serious and central banks’ balance sheets are continuing to swell. If their countries’ economies recover, interest rates will be revised sooner or later and capital will start to flee from the markets. The attention of the markets has recently been focused on when the US Federal Reserve will begin to scale back its third round of quantitative easing (QE3). It seems that market participants have started to factor in a rise in interest rates in the near future. High capital liquidity has channelled new investment funds into stock markets, creating an environment in which capital is seeking higher returns than can be provided by the historically low interest rates. Under these circumstances, we examine how stocks with high dividend yields, one of the main appeals of which is high income, are expected to fluctuate and whether our previous evaluations should be revised based on these expectations.

We (Nikko AM) use the MSCI Standard Indices (STD Indices) and the MSCI High Dividend Yield Index (HDY Index) (net, Yen-converted). The STD Indices are commonly used and include the MSCI Japan Equity Index and MSCI Kokusai Index. The HDY Index comprises those stocks used for the STD Indices that meet two major requirements:

• Passing dividend continuity screening tests, and
• Producing a dividend yield exceeding the average for STD Index stocks.

For this reason, we think that the HDY Index is effective for examining how stocks with high dividend yields differ from ordinary ones in the same market.

The following charts indicate monthly returns for the two types of equity in major stock markets for the first five months of 2013 (as of May 31; net and Yen-converted).

Both the STD Indices and the HDY Index had been achieving extremely high returns since the start of the year. However, interest rates responded sensitively following the US Federal Reserve’s recent announcement about possible tapering of quantitative easing (QE). Following this, the HDY Index performed poorly compared with the STD Indices. It can be understood from the performance of these two types of indices that fluctuations in interest rates have certain effects on equity performance and that stocks with high dividend yields tend to be more affected. But can such a tendency be actually observed in the stock markets?

The chart below compares the performance of the US HDY and STD Indices with yields for 10-year US Treasury bonds. The yield for 10-year U.S. Treasury bonds trended at about 5% around 2001, but since then has fallen to nearly 2%, showing a long-term downturn trend.

After the tech bubble burst around 2000, the recessionary phase continued until around 2003. Subsequently, the economy bottomed out and then started to pick up in the five years up to the collapse of Lehman Brothers. At the same time, interest rates continued to rise, if slowly. From the start of 2003 when they bottomed out, to the middle of 2007 when they peaked, both the HDY and STD Indices moved continuously in parallel, eventually registering an increase of over 90% as interest rates trended upwards. During this period, despite the fears of some market watchers, the rises in interest rates had absolutely no effect on the performance of stocks with high dividend yields.

If these facts are taken into consideration, it is reasonable to expect that future interest rate rises will have a smaller effect on stock prices than during the previous period when interest rates were on an upward trajectory. A similar tendency was observed in Europe, Japan and Australia (see charts below), and there was no evidence that the performance of stocks with high dividend yields was conspicuously inferior.

Stable changes in stock prices expected for high-dividend-return equity

Stock prices tend to rise when interest rates go up and to fall when interest rates go down. In addition, it seems that the STD Indices experience greater stock-price fluctuations than the HDY Index. Since the time period examined in this report included a period of economic deterioration during which investors became adverse to risky assets as the future of the economy became increasingly uncertain (the so-called risk-off effect), this does not necessarily suggest future trends in these indices. However, it does appear that over a long period of time, as interest rates fluctuate, stocks with high dividend yields are more stable than ordinary stocks. The analyses of the European, Japanese and Australian markets all produced similar results.

Appeal of high-dividend-return stocks unlikely to wane

Market watchers hold various expectations for the future based on the prospects for economic recovery and rises in interest rates. However, it cannot necessarily be said that stocks with high dividend yields are more affected by fluctuations in interest rates. From a longer-term perspective, it is unlikely that the appeal of stocks with high dividend yields will diminish because they can avoid risks at the same time as earning a higher return than ordinary stocks.  In addition, we expect an increasing number of investors will seek high income (dividends) and companies will attempt to respond to such expectations by paying more dividends and raising their payout ratios. It’s likely that this will, in turn, lead to improved evaluations of the prices of stocks with high dividend yields. 

Disclaimer

Parts of this document have been prepared by Nikko AM. Nikko AM carries on business in Australia through its wholly owned subsidiary Tyndall Investment Management Limited ABN 99 003 376 252 AFS Licence 237563 (Tyndall AM). To the extent that any statement in this document constitutes general advice under Australian law, the advice is provided by Tyndall. Nikko AM does not hold an AFS Licence. This material has been prepared for general information purposes only for sophisticated investors.

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Is the super cycle over?

Time to move on from commodities to global stock picking

Morgan Stanley last week joined a growing list of big investment banks beating a partial retreat from commodities trading. Like Barclays, UBS and Deutsche Bank, it is struggling to make sense of a business where revenues have tumbled since the hey-day of the natural resources boom immediately prior to the financial crisis. So is the commodities super-cycle over?

For three reasons, I think the remarkable rally in the prices of energy and metals (although maybe not food which marches to a different beat) may have ground to a halt. If so, this might have big implications for investors.

The first headwind for commodities prices going forward is the likely strength of the US dollar, the currency in which most resources are priced. As the US currency rises in value, commodity producers are prepared to accept a lower price because their income remains unchanged in their own currency. And why should the dollar appreciate from here? A combination of economic recovery, interest rates returning to pre-crisis norms, a better trade balance and structural improvements in America’s fiscal situation. Put these together and I expect a decade-long dollar decline to reverse.

The second key driver of commodity prices is demand and here too the outlook points to further declines. The principal reason for this is the ongoing rebalancing of the Chinese economy away from manufacturing, infrastructure investment and exports to domestic consumption. This coupled with a slowing in the overall rate of GDP growth in China means the country, while clearly still a big consumer of resources, will have less of an impact on prices at the margin. Five years ago, exports and private consumption both accounted for about 35% of Chinese GDP but in five years’ time those proportions will probably have become 25% and 40% respectively, a huge relative shift in only ten years.

Thirdly, even as demand for commodities is likely to moderate, the supply of energy and metals is expected to increase in the years ahead. This is a natural consequence of a decade of rising prices which has made previously unviable extraction of, for example, oil from Canadian tar sands financially worthwhile. It is also a result of technological advances, the main driver of the Shale gas revolution in the US about which I’ve written here a few times.

So a combination of dollar strength, weakening demand and increased supply looks like a recipe for lower commodity prices from here. What does this mean for investors?

Firstly, I think it will be broadly supportive of global growth. Lower energy costs increase disposable incomes for individual consumers and cheaper energy and metals reduce input costs for industry.

Secondly, weakening commodity prices contribute to the relative attractiveness of developed markets such as the US, Japan and Europe compared with emerging markets. The West is principally a consumer of commodities and the developing world a producer, although clearly this is a generalisation which will be less true in time as and when the US overtakes Saudi Arabia to become the world’s leading oil producer.

Thirdly, lower commodity prices are likely to lead to lower inflation, which in turn provides central banks with the cover to keep monetary policy looser for longer. In this context, I think the nervousness over the Fed’s tapering of quantitative easing may well have been overdone. The big problem in many economies is debt, public and private, and that makes them extremely sensitive to rising interest rates. Policy will remain easy for longer than some people now believe.

Finally, easing commodity prices could lead to a reduction in the risk-on, risk-off, macro-driven market movements which have characterised investment for the past few years. For one thing, the free lunch in emerging markets looks to be over. The rising tide has lifted all boats in the developing world and investors are going to have to be much more discriminating with their emerging market investments. My colleague Anthony Bolton’s long-held belief that investors will start to differentiate between those companies in China exposed to rising consumption, and those still dependent on an increasingly redundant export and investment model could come good just as he hangs up his boots next year.

Winners and losers from the end of the commodity super-cycle will be found at the country level and among individual stocks and sectors. Domestic Chinese airline, US steel-maker or Australian iron-ore producer? Working out where in the supply chain the real pricing power resides will be key. Trading commodities may not be very rewarding right now but it’s never looked a better time to be a bottom-up global stock picker.

By Tom Stevenson, Investment Director, Fidelity Worldwide Investment

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This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment.

Prior to making an investment decision, retail investors should seek advice from their financial advisers. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise. 

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Fed’s QE exit

We have known for some time that Ben Bernanke has worried about the build-up of risks stemming from investors’ reach for yield which has ultimately stemmed from the Fed’s highly accommodative monetary policy. On the other hand, we also know that Bernanke is fully cognisant of the risks associated with any sudden pick-up in yields from current depressed levels. Indeed, if bond yields were to rise too quickly upon commencement of the exit process, we would expect the Fed to manage the market’s expectations, possibly by pausing, or even temporarily reversing, the normalisation process.

Interestingly, in his March 1st speech, Bernanke pointed out that if policy rate hikes were implemented too soon this could even cause bond yields to fall. Although he did not explain how, it is our view that one way this could happen would be if an initial rise in yields caused a jump in interest costs, leading to a reduction in disposable income and slower demand for housing.

The 1994 comparison

Of the four rate-rising cycles since 1988, only the 1994 cycle resulted in the US 10-yr yield ending the cycle more than 75bps higher than when the cycle started. Thus only in 1994 did we have a relatively disorderly impact from Fed policy normalisation, with the rate rising cycle resulting in a capital loss on bonds. However, with coupons at 2% or lower, yields rises of 25 basis points or more per year will generate a capital loss.

To be clear, whenever policy rates are normalised, bond yields will go higher. However, that does not mean we will necessarily experience the disorder of 1994. It is difficult to say what the ‘new normal’ for the Fed Funds Rate will be. Assuming equilibrium inflation expectations of 2.5% and an equilibrium real short rate of 1.5%, perhaps 4% is reasonable. The Fed considers the bond yield as decomposed into an expected inflation rate plus an average real short rate plus a term premium. For example, a 2.5% expected inflation rate + a 1.5% real rate and a + 1% term premium, gives a 5% yield. But, it is the speed of the rise that is of critical importance both to investors and the economy. The good news here is that market currently believes it will take more than 10 years to normalise the Fed Funds Rate, implying a slow and manageable rise in yields.

The biggest area of concern for investors will be upward pressure on yields arising from higher inflation expectations as opposed to economic improvement and normalisation. For example, such a situation could arise if the FOMC persisted with a loose monetary stance for too long even as inflation was picking up. While we do not completely dismiss this risk, we feel this is unlikely because the Fed has stated very clearly that it will only unwind monetary accommodation once unemployment drops sufficiently and/or inflation rises beyond its threshold levels. The reference to inflation is key here because it is specifically intended to comfort the market that the Fed won’t allow inflation to become uncontrollable.

Another risk factor worth considering is an increase in the term premium. The most likely cause of this would be a deterioration of the US fiscal situation leading to increasing investor aversion to Treasuries. However, while this is also something that should not be dismissed entirely, we still see few parallels with the 1994 situation, when policy adjustment by the Fed led to a sharp spike in yields in a relatively short time frame. The big difference between now and 1994 is the Fed’s much improved communication with the market. In 1994, yields rose quickly because the market was effectively caught out and surprised by FOMC’s intentions – the FOMC had only recently began to issue policy statements at this time. Today however, we know that the Fed places an immense amount importance on its guidance to the market. Given this, a large rise in yields is only likely if the Fed unexpectedly shifts its stance on how it intends to normalise policy. While such a “blind-siding” in terms of market perception and Fed actions is possible, we think it is unlikely.

The sequence of the exit process is more difficult to predict, because the Fed will want to remain flexible enough to take decisions while the exit process progresses. However, an end to QE will almost certainly be the first step, followed by the winding down of treasury and agency MBS debt that was being rolled over – although this process will take place over the course of many years. As a next step, it’s possible that the Fed raises the interest rate on banks’ excess reserves (IOER) while scaling back the quantity of its reserves via repos (reverse repurchase arrangements) and offering depositary institutions term deposits. Asset sales would be a last resort to reduce the size of the balance sheet – used only in the event that the Fed wants to drain reserves faster than it currently anticipates.

Trevor Greetham, Asset Allocation and Investment Solutions Director, also commented: “Over the longer term, it is natural for bond yields to rise during an economic recovery and this isn’t usually a problem for stocks as long as the rise in yields is orderly. That said, the debate around QE exit is premature. US data has been weak and lead indicators are rolling over. Meanwhile, US headline CPI is 1% and falling. This data is more consistent with easing than tightening.”

By David Buckle, Head of Quantitative Research, Fidelity Worldwide Investment

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This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment.

Prior to making an investment decision, retail investors should seek advice from their financial advisers. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise. 

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This view was expressed by Mark Arnold, Hyperion’s Chief Investment Officer, who said that the evidence provided by the success of Hyperion’s investment process, with its overarching aim of identifying Australian companies with fundamentally positive long term economics, has led to this view. Hyperion was recently named Australia’s 2013 Fund Manager of the Year by Money Management.

“We are focused on long term growth potential which means we look at sectors and companies alike over a five- to ten-year time horizon, and hold stocks for an average of ten years. And when it comes to the ability to realise growth potential, small-cap and medium-cap companies are often better placed than the big players,” said Mr Arnold.

“We start by assessing a company’s addressable market over a ten-year period, which means looking at the sector as a whole. If the sector is growing and the company is small relative to the market, it has higher organic growth potential, and that means better returns over time.”

Mr Arnold further explained that Hyperion looks for two factors when identifying companies likely to outperform: a high quality franchise which must include a sustainable competitive advantage and the potential for long term revenue and profit growth.  Companies should also be capital light and should not carry excessive debt.

By way of example, Mr Arnold pointed to online businesses such as realestate.com.au, seek.com.au and carsales.com.au, all of which operate in a growing sector and all have been an important part of the Hyperion portfolio for some time.

“Each of these companies has a sustainable competitive advantage and a strong value proposition which in turn produces pricing power,” he said.

Another example of Hyperion’s investment process in action is JB Hi-Fi. When Hyperion bought the stock a decade ago, all it had to offer was an attractive retail story and a small number of stores, primarily in Victoria. Hyperion saw the potential for the company to be rolled out into other States, and it performed very well for investors. Hyperion has since sold out of JB Hi Fi, because it is now a mature stock with a less compelling growth story.

Size isn’t the whole story, however. Hyperion expects to achieve similar strong results with Brambles, a large company, but one that is targeting growth by driving successful products into new markets.

According to Mr Arnold, another favoured story at Hyperion is global rollouts.

“Products which are successful in one geographic location can often perform successfully in others,” he explained.

“That’s why we have invested in the University pathway provider, Navitas, and financial software provider IRESS Financial Solutions. Both have products that have proven themselves here, and are now being rolled out in other countries including the UK, the US and Canada.”

Mr Arnold then said that, while Hyperion is strictly a bottom-up, fundamentals-based investor, it also bears mentioning that companies in certain sectors often share some common features that do marry with this investment approach. In general, these are sectors that benefit from ‘secular tailwinds’; meaning that businesses in the sector operate in growing markets.

“Healthcare is a great example. An ageing population means that demand for healthcare services is increasing all the time. That’s why we like Ramsay Health Care. What it all comes down to is an ability to assess every company on its long-term economic merits,” concluded Mr Arnold.

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